IPOs as Lotteries: Skewness Preference and First-Day Returns

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For decades, economists have understood investment decisions in terms of a rational framework that considers the likelihood of payouts from an investment, the degree of risk aversion on the part of an investor and variations in the usefulness of the same payout to different buyers. Yet a growing body of research suggests that this focus on expected utility fails to explain all types of investor behavior. In particular, dominant economic theory fails to explain why many individual investors seem captivated by the prospect of lotteries as they place high subjective valuations on large but low probability gains, says T. Clifton Green, an associate professor of finance at the Goizueta Business School. In a recently published paper, Green and a colleague at Purdue University set out to document whether individual investors’ preference for lotteries could play a role in pumping up the price for initial public offerings of stock. The concept they investigated is called “skewness” — a measure of the asymmetry in the probability distribution of values — and they found that IPOs with this lottery-like characteristic have significantly greater first-day returns that dissipate over the long-run. The study also documented a link between high expected skewness and an increase in the number of small-size trades on the first day of trading, a finding that fits with the notion that IPO lotteries are more attractive to individual investors than those representing institutions.

The study analyzed nearly 8,000 initial public offerings of stock during the 1975-2008 period. Firms were classified into 30 industries and researchers posited that IPO firms from industries that had highly positively skewed returns in the past were more likely to be viewed by investors as also having lottery-like features. Next, researchers calculated differences in average initial returns across IPOs depending on whether they had low, medium or high expected skewness. High skewness IPOs, on average, experienced an initial return of 25.78 percent, the researchers found, whereas low-skewness IPOs had an average initial return of just 11.44 percent. The effect played out across most years in the sample, and therefore wasn’t simply driven by a cluster of IPOs during a few of the years studied. If individual investors show a preference for investments with lottery-like features, the same measures of expected skewness that predict first-day IPO returns also should predict a larger fraction of trades from individuals on the first day of trading, the researchers stipulated. They looked for evidence to support or challenge the theory by analyzing a subsample of all IPOs between January 1993 and August 2000 – the only time period when data on the issue was readily available. After controlling for firm, deal and market and characteristics, the researchers found that a one standard-deviation increase in their measure for skew translated to a 0.67 percent increase in the fraction of small trades, relative to an average of rate of 5.7 percent. Finally, researchers looked at the long-run performance of IPOs and found that those with high expected skewness significantly underperformed other stocks. In the five years after the offering, the difference in abnormal returns between low and high-skewness IPOs grows to 31 percent, the researchers found. The results suggest investors with a preference for lotteries impact price, the researchers said, and cause stocks to become overpriced and subsequently deliver relatively low returns.

Traditional explanations for why some IPO prices jump on the first day of trading have focused on information asymmetries and the effects of over-optimism among investors, the researchers pointed out. The new study does not challenge those theories, but simply offers a preference for skewness as an additional contributing factor. The results suggest that institutional investors and IPO underwriters might not fully recognize the added value that individual investors place on securities with lottery-like characteristics, the researchers wrote. But at the same time, it could be that primary market participants recognize the impact of skewness, but choose not to incorporate the information due to concerns about litigation or a reputational risk if they’re seen as potentially overpricing an IPO.

“The results suggest that skewness preference is an important incremental source of first-day IPO returns,” the researchers concluded. “To the extent that primary market participants do not fully incorporate individual investors’ skewness preference when setting the offer price, examining the effect of an IPO’s expected skewness on first-day returns provides an interesting setting to test the hypothesis that securities with lottery-like return distributions can become overpriced.”